This upcoming proxy season, most public companies will be required to include disclosure under Item 402(u) of Regulation S-K (Pay Ratio) for the first time. The Pay Ratio rule was introduced by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and the Securities and Exchange Commission (SEC) later promulgated rules putting it into effect for fiscal years starting after January 1, 2017. The final rule requires public companies to disclose the ratio of the compensation of the company’s principal executive officer (CEO) to the compensation of the company’s median employee. The Pay Ratio disclosure must be included in proxy statements for the 2018 season, or in the Form 10-K if no proxy statement is filed. Importantly, the Pay Ratio requirements do not apply to smaller reporting companies, emerging-growth companies or foreign private issuers.

Disclosure of the Pay Ratio

Under the Pay Ratio requirements, subject public companies must disclose:

  • the median of the annual total compensation of all employees (other than the CEO),

  • the CEO’s annual total compensation, and

  • the ratio between the two.

The required disclosure of the ratio can be provided either as a factor (i.e., the Pay Ratio is 200:1) or as a multiple of the median employee’s compensation (i.e., the CEO’s compensation is 200 times that of the median employee’s compensation). The company can provide additional, optional information to aid in the shareholders’ understanding of the ratio. So companies will not only need to disclose, but also determine the best way to present the Pay Ratio information to their shareholders.

Determination of the Median Employee

Generally, in determining the median employee, all employees of a company, even part-time and seasonal employees, must be included. However, there are exceptions that generally allow exclusion of independent contractors, leased employees and certain employees in foreign jurisdictions.

On September 21, the SEC issued interpretive guidance to assist companies in complying with the Pay Ratio disclosure requirements. This guidance focuses on methods for determining the types of compensation that will be included in the annual compensation of a company’s employees and identifying a company’s median employee.

The SEC guidance does not set forth a specific methodology to determine compensation of each employee, but provides that, in determining the median employee and employee compensation, a company may use “reasonable estimates, assumptions, and methodologies; and reasonable efforts to prepare the disclosures.” Due to cost and complexity concerns, a public company does not have to determine its median employee based on a measure of compensation that corresponds to the way named executive officer compensation is measured and reported in the summary compensation table of the proxy. Instead, a company may use any consistently applied compensation measure (e.g., payroll or tax records), as long as the chosen measure is disclosed in the narrative accompanying the disclosure. However, if a company materially changes its methodology or assumptions in the future, it will have to disclose that change and the rationale for it.

Companies may use any date within the last three months of the company’s last completed fiscal year to determine the median employee. The company must disclose the date it selects for this purpose, and, if it subsequently changes the selected date, the company will have to disclose the change and the rationale for the change.

Importantly, disclosing the median employee’s identity (or any personally identifiable information about the median employee) is neither required nor permitted. Additionally, to ease administrative burden, once the median employee has been identified, the same employee may be used for three years, unless the company reasonably believes that, due to changes in employee population or compensation, a significant change in the Pay Ratio disclosure would result.

Determination of Compensation

Once the median employee is identified, in order to have an “apples to apples” ratio, the public company must recalculate that employee’s compensation for the purposes of the Pay Ratio disclosure in accordance with Item 402(c)(2)(x) of Regulation S-K (i.e., in the same way that the CEO’s annual compensation is calculated for the summary compensation table). With respect to CEO compensation, if the company had more than one CEO during a given year, the company has two options: (a) combine the compensation payable to each such person with respect to his or her time in service as the CEO or (b) annualize the compensation of the person who was serving as the CEO on the date used to identify the median employee. In either case, the company must disclose the method it selects and explain how the CEO’s compensation was calculated.

To the extent they have not already done so, public companies should now be determining the applicable median employee and determining the compensation of the selected employee in preparation for the new Pay Ratio disclosure.